Roth IRAs offer significant tax advantages — and, unsurprisingly, there are strings attached. You’ll need to abide by IRS rules for these investment retirement accounts to avoid the sticker shock of penalties or taxes when you take distributions.
Below, we cover three of the rules for Roth IRA withdrawals, all of which have a five-year stipulation to avoid penalties. One applies to the general waiting period before you can take withdrawals of investment earnings (also known as distributions), another applies to Roth conversions, and the final pertains to beneficiaries.
Here’s what you need to know about each.
Five-year rule for withdrawals
The five-year rule for Roth IRA withdrawals of investment earnings requires that you hold your account for at least five years before you can tap those earnings without incurring a penalty. It’s important to note this rule applies specifically to investment earnings. The contributions you’ve made can be withdrawn at any time because you’ve already paid taxes on this money.
This rule determines whether a withdrawal of earnings will be considered tax-free by the IRS. If it’s not, you may be liable to pay taxes and a 10% penalty on the earnings portion of your distribution. (Here’s what you need to know if you’re considering an early withdrawal.)
It’s important to note this rule applies specifically to investment earnings. The contributions you’ve made can be withdrawn at any time because you’ve already paid taxes on this money.
The five-year period begins on Jan. 1 of the year you made your first contribution to any Roth IRA. Once you clear that five-year period, for withdrawals of earnings to qualify as tax-free, they must also be done after age 59½ or because you qualify for certain exceptions. If you’ve had your Roth for less than five years, there are also exceptions that can get you off the hook for the 10% penalty on withdrawn earnings — but not all income taxes.
|Early distributions of earnings for these reasons are considered qualified: not subject to taxes or the 10% penalty||Early distributions of earnings for these reasons are considered exceptions: taxable as income, but not subject to the 10% penalty|
| You've held a Roth IRA for at least five years AND you are taking the distribution in one of the following circumstances:|
• You're age 59 1/2 or older
• You're permanently and totally disabled
• As a beneficiary of the Roth IRA after death of the account owner
• To use up to $10,000 for a first-time home purchase
|• You are taking the distribution for qualified education expenses
• You are taking the distribution for unreimbursed medical expenses that exceed 7.5% of your adjusted gross income for the year or health insurance premiums while you are unemployed
• You are taking qualified reservist distributions (for members of the military reserve called to active duty)
• You are taking a series of substantially equal distributions
• The distribution is due to an IRS levy
• You have not held a Roth IRA for at least five years, but you are 59 1/2 or older, permanently and totally disabled, inherited the Roth IRA after death of the account owner or using up to $10,000 for a first-time home purchase
Five-year rule for Roth conversions
Similar to the rule above, withdrawals of money from the conversion of a traditional IRA or 401(k) to a Roth IRA are subject to a five-year waiting period to avoid a penalty.
The five-year period begins the first day of the tax year in which you converted money.
For this rule, the five-year period begins the first day of the tax year in which you converted money from a traditional IRA (or did a rollover from a qualified retirement plan) to your Roth IRA. For example, if you do a conversion in the month of May, the rule for that conversion begins on the prior Jan. 1. Each conversion or rollover you make is subject to a separate five-year waiting period.
» Read more: Is a Roth IRA conversion right for you?
If you don’t wait the requisite five-year period from conversion to withdrawal, you may have to pay a 10% penalty, along with any income taxes owed. The same exceptions apply to the five-year rule of withdrawals of conversions as any other type of early distributions — see chart above for examples).
Five-year rule for beneficiaries
The final five-year rule applies to distributions to beneficiaries of a deceased IRA holder. As noted by the other two rules, death is an exception to penalties for early withdrawals — but to avoid ordinary taxes, beneficiaries still must abide by the two prior rules pertaining to the waiting period for making withdrawals of investment earnings or converted amounts.
» Read more: Learn about your options when you inherit an IRA
If you’re the beneficiary of a Roth IRA, double-check the timing of initial contributions, conversions or rollovers.
As a result, if you find yourself to be the beneficiary of a Roth IRA, double-check the timing of initial contributions, conversions or rollovers. Distributions of earnings and rollovers won’t necessarily qualify as tax-free if any of the five-year rules prohibit it, even though the original owner of the Roth IRA has died. Those amounts will be included in the beneficiary’s gross income and therefore subject to income taxes, just as if the money had gone to the original IRA owner instead.